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May 15, 2011

The REAL Oil Business (Part 3, Offshore Texas or Bakken) Reprised from 8/07

Open Choke reader Tex Dinero, a hell of a great American, who said he was gonna name his next hunting dog after me, asked me where I would put 50 mil... in shallow State waters wells or Horizontal Bakken wells. What a GREAT question, and one that allows me to further explain the inner workings of the US oil and gas business.

To begin, let's describe each play. The target for State waters wells are gas sands visible on seismic data. The prospect brochures I have seen tell me that wells cost around $6 million drilled and completed, $7 mil with land, geology and geophysics, and can produce 40+ million cubic feet of gas per day, with ultimate EUR's of 40-60 BCFG. Of course, those are brochure stats. Real stats, like those available from my friends at Drillinginfo, tell a somewhat different story.

The real story... the average Texas State waters well will make between 3-4 BCFGE, and the best wells will make a little over 20 BCFGE. The average initial production is around 4 million cubic feet of gas per day.

I ran a quick ec0nomic analysis for a 3.25 BCFGE proxy well, and found that the ROI is around 2.5:1, and the IRR is around 60% using todays oil and gas prices and a $5k per month operating cost. Payout for one of these bad boys is 20 months. Not too bad.

Next, we gotta factor in the dry hole rate of around 50%. Think of it this way. You have a 1 in 2 chance of losing all of your money, and a 1 in 2 chance of getting some to a whole lotta money back. Of the 1 in 2 where you get money back, you have a 1 in 2 chance of not getting your money back, so a 3 in 4 chance of not breaking even. You have a 1 in 4 chance of making a profit. You have a 1 in 10 chance WITHIN the 1 in 4 chance of making, or a 1 in 40 chance of making 7.5 times your money. You have a 1 in 4 chance of making 2.5 times your money. If your brain spins thinking about this kinda thing, stay the hell outa the oil business!

Typical Strategy, the old style portfolio management approach, dicates that you earmark the 50 million to drilling 8 net wells (40 million dollars) that yield 4 net producing wells (8 million in completion costs) that will ultimately return 13 BCFGE (1.3 to 2.1 MMBOE) for a net return of around 80 million on your 50 million dollar investment. As we say in the usiness, Rope Soap and Dope, meaning all in. Your IRR should be around 30% in a global commodity that is less and less tied to the dollar. A pretty great hedge against Chinese threats to the almighty dollar and stock market collapse. A lot worse places to put your moolah.

The Bakken. Oil. Lets compare... First, let's create an oil to gas equivalency... BCFGEquivalent. Engineers like to create an equivalency on a heating, or BTU, basis... 6000 cubic feet per barrel of oil. 600,000 cubic feet per 100 barrels per day. 6 billion cubic feet per 1 million barrels. I am not a huge fan of this method. Since oil sells for more on a BTU basis than gas, and since we are in the business of manufacturing dollars, I like to make a dollar equivalencybetween the two. Gas is around $7 per MMCFG, and Oil is around $75 per BO. For the sake of simplicity, let's just say 10:1.

The Bakken is what's called in the industry a statistical play. It comprises a dolomite "bench" within a very rich source shale. Statistical plays mean that you drill every legal location. Unlike a more classical oil and gas deposit, where the reservoir is very discrete, and you lease a lot of unproductive land to get at the small pearl of valuable acreage, every bit of land you lease in a statistical play is drillable. In fact, the amount of hydrocarbons you can produce is linearly dependent on the amount of land you lease. Think of your land position to the size of an assembly line. A typical Bakken well produces 195k barrels of oil equivalent per well, or 1.95 BCFGE at an initial rate of 175 barrels of oil per day equivalent ( 1.75 MMCFGE). Drilling costs are around $4 million with 320 acre spacing. Lets compare to offshore Texas waters.

Bakken Offshore Texas

Drill/Complete $4 million $6 million

Land/Geol/Geoph $0.165 million $1 million

Reserves 1.75 BCFGE 3.25 BCFGE

Initial Daily Production 1.75 MMCFGE 4 MMCFGE

Raw $/MCF $2.38 $2.15

Drilling Success 95% 50%

Risk Adjusted $2.50 $4.30

So, on a well by well basis, the Bakken looks better on a Risked ROI point of view and the Offshore looks better from a risked IRR point of view. Either look good, right? About the same? This completes the easy, learn it in a schoolbook assessment. Now lets look at the REAL assessment.

The answer is that the Bakken is a far FAR better investment... if you do it right.

The reason? Instead of 2 MMBOE, you will be accessing 52 MMBOE, and your challenge will be to make it more economic, which means betting on human ingenuity instead of betting on Mother Nature. How to do it right? Here's how.

Step 1. Invest most of your money in leasehold. In this case, pick up 150 sections at $400 per acre, or $38 million... hopefully in ten year leases,

Step 2. Drill 3 wells to establish production. Not only do you establish production, but you define 12 Proven Undeveloped Locations (PUDs). While you are at it, get the best completion engineer knowledgable in the trend and pay him or her whatever they ask.

Step 3. Use your initial declining 500 barrels per day from those three wells and your leasehold position to access Mezzanine financing, which will cost you all in 18-30%. Don't worry if the financing cost exceeds the per well return. Pretend you're Enron. You will see why later. You should be able to structure it so that you are guaranteed, say $20 million, with expansion financing based on success.

Step 4. Hire two rigs to drill 2 wells per month on your PUD's. IMPORTANT- make sure you drill your furthest out PUD's first to establish even more PUD's and continue to drill your furthest out PUD's in order to create even more PUD locations. The WORST thing to do is to drill your original PUD locations. You haven't expanded your leveragable property if you do that.

Step 5. After 2-3 months, expand your program to 3 rigs per month. What you are playing here is nested time series of numbers... and your limits are your acreage position and access to rigs. I happen to know that using this scenario, it will take 63 wells to achieve the cash flow needed to have the operation sustain itself from cash flow. You are asking yourself, What the hell? 63 wells x 4 million dollars is 252 million dollars! Well, that IS all in. If you use your cash flow to offset, you will see you will need to borrow only about $130 million. Unless you are a typical oilman and borrow $15o million and upgrade your offices and get a G4 with some of that cash flow. Jets are 100% financable right now. In any rate, at this point, you have drilled 63 wells of your 300 legal locations, and you are 2.8 years into your project. Might be a good time to sell.

Step 6. You should be able to sell your deal now for between $600 million and $750 million. Your Mezzanine lender gets his $150 mil principal, leaving between $450 and $600 mil. If you signed a crappy deal with your banker, you might need to pay him another $135 to $180 mil for the equity portion of the Mezzanine, leaving you with $315 to $420 mil. That's a cool 6 to 8.5:1 return on your original 50 mil investment and well over 100% IRR in 3 years.

Alternative.- Now that you can drill from cash flow, refinance your Mezzanine to Bank finance, you have an asset of a scale to do so. Drill it all up, have a bunch of free cash flow to live the life of Riley with little exposure, and sell it to a company that is sure that it can drill it on 160 acre spacings.

Early Alternative- After your first three wells, sell 50% of your deal for $50 million and have a no risk hedged position for half the upside.

Of course, this is the perfect world scenario. The real world is a l'il different, and I will cover that in a later column.

That is the game with these land plays... and why we pay so much per acre... the opportunity to hugely leverage. The richest sons of a bi... guns know this fundamentally. While everyone laughed at John L. Cox in the 1950's for drilling his crappy little Sprayberry wells while they were drilling 25k foot Ellenberger barn burners, he quietly put half of the Midland Basin into HBP for his own account.

As ol' Jack Hightower told the Executive Oil Conference in Midland, the most important thing you can do is to cultivate close friendships with good bankers, and have a million singles lined up in front of you. The most successful oil guys I know have never hit a home run in a well or a classical prospect basis.

By the way, Tex Dinero, I hope your dawg doesn't end up a fat, lazy porch pooch with no taste for feathers like his namesake!